The financial crisis left its mark on nearly all pension portfolios, and Metropolitan Government of Nashville and Davidson County was no exception. The Nashville, Tennessee-based public pension fund had an outsize equity allocation of 79 percent before shrinking by more than a quarter in the disastrous 2008 fiscal year, from $2.2 billion to $1.6 billion in assets.

As part of a change in direction, CIO Fadi BouSamra sought out so-called alternative fixed-income strategies to take advantage of dislocated credit markets. In late 2008, BouSamra won board approval to invest $25 million, or 1.5 percent of Nashville’s assets, in Pimco Distressed Mortgage Fund II, offered by Newport Beach, California-based bond giant Pacific Investment Management Co.

That was a smart move. Through November 30, 2012, the Pimco allocation had yielded a cumulative 173 percent. But BouSamra was just getting started. In 2009, Nashville bolstered its new alternative fixed-income portfolio by committing a total of $65 million to alternative investment manager Angelo, Gordon & Co. and credit specialist Marathon Asset Management. The two New York based firms were making use of a new federal government program: public-private investment partnerships. “We’re not an endowment, but we have a lot of opportunistic and risk-aware investments,” says BouSamra, who had become Nashville’s first investment professional when he joined the then-$1.1 billion fund in November 2003.

Since 2008, Nashville has halved its target equity allocation and taken stakes in some two dozen alternative fixed-income funds. For the three years ended November 30, these investments returned an annualized 16.74 percent. Alternative fixed income makes up 15 percent of Nashville’s total portfolio, which at $2.1 billion is almost back to its precrisis level. Devoting 30 percent to traditional fixed income no longer works, says BouSamra, who now targets 20 percent. With yields below 4 percent, explains the former American Express Financial Advisors stockbroker, “that model is yesterday, and it’s broken.”

 Metropolitan Government of Nashville and
 Davidson County CIO Fadi BouSamra

Fixed-income alternatives aren’t new, but they’ve evolved. They first appeared in the 1980s, when Michael Milken of New York investment bank Drexel Burnham Lambert began peddling high-yield, or junk, bonds. Since the recent credit crisis, pension plans have stepped into a void left by banks and fellow lenders like GE Capital and CIT Group, investing in vehicles created by hedge fund firms and other alternative managers. Also, the second and third Basel Accords and other global regulatory standards have forced banks to set aside capital in case borrowers with no ratings default on their loans. “Borrowers are not willing to shell out a huge fee to Moody’s and S&P,” explains Barbara McKee, principal and co-founder of White Oak Global Advisors, a San Francisco-based firm that offers alternative fixed-income products. For their part, banks avoid such loans because they don’t want to pay equity-size premiums, McKee says. That’s left a big opening for managers like White Oak to offer loans, package them and sell them to pension investors.